The time has come for private companies to implement ASC 842 Leases. Such entities may feel a bit like the young boy at the beginning of The Polar Express, hesitant to heed the conductor’s advice to climb aboard. But the time has come to join public business entities (PBEs) and account for lease arrangements on their balance sheets. Luckily, ASC 842 does include a handful of “golden tickets” (i.e., practical expedients) that may be useful for private companies to consider. This blog covers three practical expedients within ASC 842 that simplify the recognition and measurement requirement, making their journey implementing ASC 842 a bit easier. All aboard!

Short­-term leases

The first practical expedient private companies should consider relates to the ability for lessees to designate arrangements as short-term leases. A short-term lease is defined as a lease that, at the commencement date, has a lease term of 12 months or less and that does not include an option to purchase the underlying asset that the lessee is reasonably certain to exercise. ASC 842 allows such arrangements to be accounted for as executory contracts. That is, these arrangements do not need to be capitalized on the balance sheet with a corresponding lease liability and can instead be expensed as incurred on a straight-line basis. The short-term lease practical expedient is an accounting policy election by class of underlying asset and can only be elected at the commencement date.

Private companies may find the practical expedient related to short-term leases very helpful as it could save them some time related to analyzing their portfolio of lease arrangements. However, keep in mind that there is still a requirement for entities to disclose the cost of leases (including those designated as short-term leases) within the financial statements. So, entities will still have to capture such information for financial reporting!

Not separating lease and non-lease components

As discussed in this blog, ASC 842 requires entities to identify the various components within a contract. This includes:

• Lease components
• Non-lease components
• Other components that are not components of the contract

Lease components relate to a lessee’s right to use the underlying asset. Non-lease components are any items or activities within an arrangement that transfer a good or service to the lessee. One common example of non-lease components are charges related to common area maintenance. Charges related to administrative tasks or reimbursement of the lessor’s costs are examples of items that are not components of the contract. Examples of such items are payments related to property taxes or insurance.  

It is important to identify these various components, as ASC 842 requires the consideration be allocated between lease and non-lease components. It is the payments related to the lease components that are discounted to determine the amount of the lease liability to be recorded in the balance sheet. The accounting for non-lease and other components that are not components of the contracts is outside the scope of ASC 842 and usually follows guidance found in other Codification Topics.

Enter the second practical expedient, which is available to both lessees and lessors! Lessees may choose not to separate non-lease component(s) from the related lease component(s). If elected, the lessee may account for all components as one component. This election is available by class of underlying asset. Lessors are also allowed to combine both lease and non-lease components as a single arrangement. However, there is an additional hurdle for lessors to analyze the arrangement as a whole and apply the most appropriate guidance to the resulting transaction (i.e., ASC 842 or ASC 606).

While this practical expedient may save some time with the mechanics of allocating consideration to the various components of an arrangement, entities utilizing this practical expedient will inevitably present higher lease liabilities and right-of-use assets in the financial statements. In addition, this election requires additional disclosures to help readers understand the accounting policy election, the class or classes of underlying assets impacted, as well as the nature of the lease and non-lease components included in these arrangements.

Use of a risk-free rate

In ASC 842, the use of the discount rate is much like the coupling system on a train. The discount rate connects multiple sections of the guidance and reflects the economics of the underlying transaction. Discount rates are used to determine initial lease classification, calculate the present value of the lease payments, and measure either a lessee’s lease liability or a lessor’s net investment in a lease. Accordingly, there are very specific rules to follow when determining the appropriate interest rate to apply to a lease arrangement.

ASC 842 requires lessors to use the rate implicit in the lease as the discount rate. Lessees must also use this rate, if known. However, most of the time lessees are forced to fall back to the incremental borrowing rate. Before I go further down the rabbit hole, were you thinking that you need a refresher on the interest rate implicit in a lease or the incremental borrowing rate? Well, you are in luck! Chris outlined these concepts (as well as some very recent changes to the practical expedient guidance for discount rates!) in his most recent blog!

Wondering how to calculate these rates? Luckily, private entities do not need to feverishly search for their financial calculator thanks to the third practical expedient. Private entities, and private entities only, may elect a practical expedient to bypass the calculations and assessment of both the rate implicit in the lease, as well as its incremental borrowing rate, using instead a risk-free rate. This election can be made by each class of underlying asset, which provides some flexibility to practitioners.

It is important to keep in mind some potential drawbacks to electing this practical expedient. In addition to expanded disclosures, entities may find themselves recognizing a higher lease liability given today’s low-interest-rate environment.

Are you looking for a comprehensive set of courses to help you with the requirements of ASC 842? Well, you are in luck! Check out our ASC 842 Leases collection!

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